Saturday, May 17, 2008

He’s committing the mercantilist fallacy, that exports are either the point of trade or that they make us rich. No, it is imports that make us rich, exports being merely the shite we ship abroad to pay for them.

When Tim talks about this, I humbly suggest, he is leaving something out. When his opponents talk about this they include the thing Tim leaves out, but they leave out everything else. That thing is money or, as Smith says, gold and silver. In both cases, as we'll see, an even more important factor is left out.

I'm not suggesting Tim is unaware of these things - he's trying to make a point concisely, and I'm trying here to tease it out.

For Tim's opponents, and for Mercantalists generally, it's as though trade were a question merely of money changing hands. If we have £500 of exports and £600 of imports, it's as though there were a huge treasure chest sitting in the middle of a Whitehall office, and during the course of a year £600 was taken out and only £500 put back in. So we're £100 down.

That's obviously not the case; they're ignoring the goods (and services) that are purchased and sold in each transaction. In a free economy (so real transactions only approximate to this in varying degrees), every trade is mutually enriching. In practice, as Smith pointed out, this is not always the case. Human distortions can transform a mutually beneficial system into one of grotesque exploitation. In the chapter cited above, he wrote, in the context of the Americas:

The savage injustices of the Europeans rendered an event, which ought to have been beneficial to all, ruinous and destructive to several of these unfortunate countries

The cost of goods and services is implicit when you write about imports and exports, but for Mercantalists, this isn't an implicit thing, it's explicit. They really are thinking about the money. And Smith started this chapter talking about gold:

THAT wealth consists in money, or and silver, is a popular notion which naturally arises from the double function of money, as the instrument of commerce and as the measure of value. In consequence of its being the instrument of commerce, when we have money we can more readily obtain whatever else we have occasion for than by means of any other commodity. The great affair, we always find, is to get money.

As for a rich man, so for a rich nation, he went on. This was the misconception he wanted to correct. There's a very interesting passage later on in this chapter about the effect of increasing the amount of gold a nation possessed. If the idea of the treasure chest were right then if a nation acquired more gold, it would be richer. American gold greatly increased the quantity of gold in Europe. Was Europe richer? No, the value of gold fell. It's beautiful:

It is not by the importation of gold and silver that the discovery of America has enriched Europe. By the abundance of the American mines, those metals have become cheaper. A service of plate can now be purchased for about a third part of the corn, or a third part of the labour, which it would have cost in the fifteenth century. With the same annual expense of labour and commodities, Europe can annually purchase about three times the quantity of plate which it could have purchased at that time.

We add 'value' to our economy - we boost our wealth - every time someone somewhere in the UK sells something for more than it cost, allowing for the fact that they might have altered it, assembled it, or that it might be entirely an artefact of themselves, like services and software. It's what we add to the mix of imports and exports, and Smith also brought this into the equation, pointing out that imports can include raw materials that are then processed into something of greater value. Adding value has costs, but some of these are socially beneficial - like jobs. Sometimes the fact that an economic activity has costs is enough justification, as Friedman pointed out in the context of the Great Depression.

It's depressing, really, that so many of the people who invoke Smith and Friedman so frequently overlook the complicated, layered, undogmatic and practical nature of their arguments. Friedman argued for some government intervention in all circumstances and for even more intervention in some, exceptional circumstances. Smith was alive to the fact that 'savage injustices' on the part of the powerful lead to appalling consequences in "free" markets. From my, still limited, reading of him I have noticed that the times he becomes most ironic or scathing are when he is excoriating the behaviour of the very types of people who, today, are among those most likely to quote him. But moving on:

Smith compared the trade between Europe and the Americas with that between Europe and the East Indies. In the case of the East Indies, there were government monopolies; in the case of the Americas there was, essentially, private enterprise:

Europe, however, has hitherto derived much less advantage from its commerce with the East Indies than from that with America. The Portuguese monopolized the East India trade to themselves for about a century, and it was only indirectly and through them that the other nations of Europe could either send out or receive any goods from that country. When the Dutch, in the beginning of the last century, began to encroach upon them, they vested their whole East India commerce in an exclusive company. The English, French, Swedes, and Danes have all followed their example, so that no great nation in Europe has ever yet had the benefit of a free commerce to the East Indies. No other reason need be assigned why it has never been so advantageous as the trade to America, which, between almost every nation of Europe and its own colonies, is free to all its subjects.

The important part about this, surely, is that while imports generally will make you richer - if they didn't you wouldn't import them, on the whole - exports can also make you richer. It depends on the circumstances. The free and private enterprise that characterised the trade between North America and Europe enriched both parties, whereas the restricted monopoly trade between Europe and the East Indies still enriched Europe, but didn't enrich the Indies to the degree enjoyed by America. In fact, it enriched Europe less as well, in Smith's argument. I'm making this emphasis, because it is so important in the context of the current debates about trade with poor countries. Charities often encourage protectionism, and this impoverishes the people they are trying to help.

The argument for free trade is strongest when exercised on behalf of the exporting party, something we can clearly see in the contemporary case of Africa, which suffers from an absence of economic freedom both internally and externally. Fair Trade isn't fair to those it seeks to protect; free trade is always fair in the absence of coercion and this is especially important to the weaker party.

There's a very practical aspect to all this. If you accept that the ratio of imports to exports (the treasure chest theory) is all, then there are two principal political tools for economic management (emphasis added):

The two principles being established, however, that wealth consisted in gold and silver, and that those metals could be brought into a country which had no mines only by the balance of trade, or by exporting to a greater value than it imported [this is the Mercantile system, in an nutshell], it necessarily became the great object of political economy to diminish as much as possible the importation of foreign goods for home consumption, and to increase as much as possible the exportation of the produce of domestic industry. Its two great engines for enriching the country, therefore, were restraints upon importation, and encouragements to exportation.

It follows that if you don't accept these principles, and you shouldn't, then these two instruments should not be used.

We now use currencies that are not directly backed by gold (the "Gold Standard" recommended recently by American Presidential nomination candidate Ron Paul). Smith, however, pointed out that governments always devalued currencies, from clipping bits off coins, through debasing the metals used to manufacture them, to printing money anyway, even if they were supposedly restrained by gold reserves. I believe Friedman made this point as well, but can't find the reference for the moment. So the more excitable Libertarian exclamations about 'fiat money' are somewhat ahistorical.

Smith suggested that money - the Treasure Chest of a nation - is not where wealth resides. Money, rather, is a convenient means of exchange. He pointed out that credit transactions (which came to characterise the European economy at least by the thirteenth century) allow trade to be carried on in advance of the money the trade represents. When this is engaged in excessively, a problem arises - overtrading:

When the profits of trade happen to be greater than ordinary, overtrading becomes a general error both among great and small dealers. They do not always send more money abroad than usual, but they buy upon credit, both at home and abroad, an unusual quantity of goods, which they send to some distant market in hopes that the returns will come in before the demand for payment. The demand comes before the returns, and they have nothing at hand with which they can either purchase money, or give solid security for borrowing. It is not any scarcity of gold and silver, but the difficulty which such people find in borrowing, and which their creditors find in getting payment, that occasions the general complaint of the scarcity of money.

It would be too ridiculous to go about seriously to prove that wealth does not consist in money, or in gold and silver; but in what money purchases, and is valuable only for purchasing. Money, no doubt, makes always a part of the national capital; but it has already been shown that it generally makes but a small part, and always the most unprofitable part of it.

It is not because wealth consists more essentially in money than in goods that the merchant find it generally more easy to buy goods with money than to buy money with goods; but because money is the known and established instrument of commerce...

Money is also useful for storing wealth for an individual merchant, because it is less perishable than most commodities - and this gives rise to another misconception, because this cannot be extrapolated into a metaphor for a nation:

But it is but a very small part of the annual produce of the land and labour of a country which can ever be destined for purchasing gold and silver from their neighbours. The far greater part is circulated and consumed among themselves; and even of the surplus which is sent abroad, the greater part is generally destined for the purchase of other foreign goods.

We now have four parts to this equation:

Money (or gold and silver)

Imports

Exports

The internal commerce of a nation

As I understand it, Smith argued that while money was not the main measure of a nation's wealth - this was something he called 'national capital' - it was a small part of that capital. More importantly it is a convenient means of exchange for things that, unlike money, you can eat, wear and shelter in.

Imports do generally make you rich, but so can exports if trade is free and plural. Smith used the example of 'the last French War' to show how the cost - something like twice the amount of gold in circulation in Britain at the time - was met by the export of commodities.

The internal commerce of a nation cannot be disregarded. Both imports and exports happen only because this internal commerce exists. Smith used a simplified example to show that such internal commerce would continue to exist even in the absence of international trade (that might seem obvious, but he sought to give a complete argument; Wealth of Nations isn't a long book, so much as a thorough one, so far as I can see).

Earlier in this post, I wrote "We add 'value' to our economy - we boost our wealth - every time someone somewhere in the UK sells something for more than it cost, allowing for the fact that they might have altered it, assembled it, or that it might be entirely an artefact of themselves, like services and software. It's what we add to the mix of imports and exports..." It's important to remember that the internal commerce of a nation consists of transactions in which value is added in this way, but in which the transactions are entirely internal and part of a chain of similar transactions that are internal. This adding of value is compounded within a country.

One consequence of this must be that importation can be enriching even in the absence of exports to "pay" for the imports, because it is this value that is used to make the payments. The wealth that is exported when a payment is made has been created within a country's economy, the goods imported enrich that country even more. Importation, therefore, is a way in which value added within, say, the software industry is turned into useful commodities, like geek T-shirts and high-caffeine drinks.

A similar argument can be made for exports - even raw materials have had value added to them by dint of their having been dug up and rendered into a transportable form. The exportation is the manner in which this value is realised.

This means that the assumed connection between imports and exports might not be as real as it seems. Imports enrich us even if we don't export (because of the effects of the internal commerce of a nation); exports enrich us, if we are trading in a free and pluralistic environment, even if we don't import. Money is a useful means of exchange, and represents some residual value, but isn't in and of itself wealth.

I'm not suggesting Tim is wrong in his assertion - he's using a pithy formulation to make a point. I'm not even making a case of my own here so much as trying to summarise what Smith wrote, as I understand it, and make some comments on it. But whether you take Tim's pithy summary, or Smith's more detailed survey of the situation as it was in the late eighteenth century, the same conclusion can generally be drawn. Free Trade without coercion is good. It enriches the wealthier nations and the poorer ones too. The case of trade between Europe and North America, especially when projected into our own day, suggests it actually benefits the poorer party more, relatively, in the long run - North America has exceeded Europe now in wealth. With genuinely free trade, Africa could start catching up.

But when making this case we have to remember the problems of coercion. There are modern, would-be Conquistadores, and sometimes they are the people making the case for free trade in a disingenuous and dishonest way. Frequently, they take in vain names like Adam Smith and Milton Friedman. And we shouldn't take them at face value.

One reason not to take seriously the economic pronunciementos of Captains of Industry is that they didn't get where they are today by reading books and reflecting on them. Perhaps Mr Warren Buffet is an exception; I don't know whether he reads many books, but he certainly seems reflective.

Well, I will suggest reading Smith - don't be put off by the length, it's very readable and in parts even funny (he seems to have had a keen and agreeably understated sense of irony). PJ O'Rorke's commentary on it is a good lead in (Books that Changed the World).